Financial Accounting Standards Board Statement No. 133 (FAS 133) (“Accounting for Derivative Instruments and Hedging Activities”), as amended by Financial Accounting Standards Board Statement No. 138 (FAS 138), establishes accounting and reporting standards for derivative instruments and for hedging activities. Briefly, FAS 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a recognized asset, liability or of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction.
The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation.                For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.        For a derivative designated as hedging the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (OCI) (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss together with any excluded portion is reported in earnings immediately.        For a derivative designated as hedging the foreign currency exposure of a net investment in a foreign operation, the effective portion of the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available-for-sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction.        For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change.        
One of the requirements for hedge accounting when using a derivative is that changes in the value of the derivative must be expected to be highly effective in offsetting changes in value (or projected cash flows) of the hedged item. When hedging with options, one issue that may arise under FAS 133 is whether changes in time value can be included in the assessment of hedge effectiveness. In a totally static hedge strategy in which the hedged items do not contain embedded options, changes in time value would generally not offset changes in fair value or projected cash flows. To allow purchased options to qualify for hedge accounting, FAS 133 permits exclusion of all or a part of the hedging instrument's time value from the assessment of hedge effectiveness. If time value is excluded from the assessment of the hedge effectiveness, then the change in the time value would have to be recognized in earnings as they occur. FAS 133 suggest two methods that can be used with respect to excluding time value changes: (i) time value being computed as the fair value of the option minus the intrinsic value; and (ii) time value being computed as the fair value of the option minus the minimum value.
FAS 133 requires derivatives to be highly effective if they are to qualify for hedge accounting. The decision of how hedge effectiveness will be measured affects the determination of whether an item is (likely to be) highly effective and potentially the amount deferred in other comprehensive income (OCI). To be eligible for hedge accounting, FAS 133 requires “Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value (cash flow) attributable to the hedged risk during the period that the hedge is designated.” (par. 20b/28b). The Statement notes (par. 389) “The Board intends “highly effective” to be essentially the same as the notion of “high correlation” in Statement 80.”
In hedging with purchased options, ineffectiveness can arise due to the dynamic nature of market prices. For example, large moves in spot prices can introduce hedge ineffectiveness. This results from the fact that the option price is a convex function of the spot rate, whereas the value of the hedged item is linear in spot. In addition, because the option price is a function of volatility, whereas the value of the underlying instrument (such as a currency, a commodity, or an interest bearing instrument) is not, changes in market volatility can lead to hedge ineffectiveness. It is noted that the change in value of an option due to changes in volatility can be excluded from the test of effectiveness; however, if this were done, changes due to volatility would have to be reported in earnings. Furthermore, the value of an option may change with time, while the value of the hedged item (i.e., the underlying instrument) does not. It is noted that the change in the value of the option due to changes in time may be excluded from the test of effectiveness; however, if this is done, changes due to time decay would have to be reported in earnings.
Methods for determining whether a hedge is highly effective include (i) the cumulative offset method or (ii) by the rolling historical correlation method. Cumulative offset methodology measures effectiveness by dividing the cumulative change in value of the derivative with the cumulative change in either fair value or projected cash flows of the item being hedged. A hedge may be viewed as effective when the cumulative offset ratio calculated by comparing these two numbers is within a range of approximately 80% to 125%. Rolling historical correlation methodology can be used before hedge inception to determine whether the application of hedge accounting is reasonable given past results. This method may also be used to measure ongoing effectiveness once a hedge is put in place. For example, the company decides to measure effectiveness based on a rolling two year correlation. 3 months into a hedge, it will measure correlation based upon the trailing 2 years which will include the 3 months' hedge results plus the 21 months' prior to putting the hedge in place. An r-squared of approximately 0.8 (correlation coefficient of 0.894) is generally considered sufficient for a company to apply hedge accounting.
With respect to options, one hedging method in which changes in time value (or at least those unrelated to changes in volatility) are considered “effective” is a so-called delta-neutral hedge. FAS 133 specifically permits a type of delta-neutral hedging in which a company hedges a fixed cash position by adjusting the notional amount of the option it owns (FAS 133, paragraphs 85-87). More specifically, FAS 133 permits a company to monitor an option's ‘delta’—the ratio of changes in the option's price to changes in the price of the underlying instrument. As the delta ratio changes, the company buys or sells put options so that the next change in the fair value of all other options held can be expected to counterbalance the next change in the value of the underlying. In general, for Call options hedging a strengthening underlying, the delta ratio moves closer to one (i.e., 100%) as the underlying strengthens and moves closer to zero as the underlying weakens. The delta ratio also changes as the time to expiry decreases, as interest rates change, and as implied volatility changes.
In some cases, delta neutral hedging of a fixed cash position achieved through adjustments to the notional amount of an option, as disclosed by FAS 133, is undesirable because it changes the economics of the strategy from, for example, a simple option purchase. Consequently, other “effective” hedging strategies compatible with a wide range of desired economic outcomes are desirable.
Terminology
Black-Scholes: A solution for valuing options developed by Fischer Black, Myron Scholes and Robert Merton in 1973 for which they shared the Nobel Prize in Economics.
Call Option: A call option is a financial contract giving the owner the right, but not the obligation to buy a pre-set amount of the underlying financial instrument at a pre-set price with a pre-set maturity date.
Collar: A combination of options in which the holder of the contract has bought one out-of-the money option call (or put) and sold one (or more) out-of-the-money puts (or calls). Doing this locks in the minimum and maximum rates that the collar owner will use to transact in the underlying at expiry.Delta: The sensitivity of the change in the financial instrument's price to small changes in the price of the underlying market prices, rates or index. Delta specifies the change in the value of a derivative as a fraction of the change in forward value of the underlying (provided the change is small). Thus, if the delta of a Euro (EUR) put is −35%, a forward appreciation of the EUR by 0.01 will reduce the value of the put by (−35%)*(0.01)=0.0035 (holding other factors constant). Other variants are also commonly used, such as the sensitivity of the value or future value of the derivative to changes in the spot price of the underlying.
Delta for a European option can be computed from the well-known Black-Scholes formula. For a put option, the formula to compute Delta isDelta=−N(−d1)e−rT,while for a call option, the formula to compute Delta isDelta=N(d1)e−rT,where: N( ) is the standard cumulative normal distribution; r is the domestic risk-free continuously compounded interest rate; T is the time to option expiration (in years); ln is the natural (base e) logarithm; F is the forward price of the underlying (to the settlement date of the option); K is the strike price of the option; is the implied volatility of the underlying exchange rate; and
      d    1    =                              ln          ⁡                      (                          F              K                        )                          +                              (                          σ              2                        )                    ⁢                      T            2                                      σ        ⁢                  T                      .  Alternatively, Delta may be calculated numerically for any pricing method employed to value a derivative.Forward Contract: An over-the-counter obligation to buy or sell a financial instrument or to make a payment at some point in the future, the details of which were settled privately between the two counterparties.Gamma: (or convexity) is the degree of curvature in the financial contract's price curve with respect to its underlying price. It is the rate of change of the delta with respect to changes in the underlying price.Knockout Call: An option the existence of which is conditional upon a pre-set trigger price trading before the option's designated maturity. The option is deemed to exist unless the trigger price is touched before maturity.Mark-to-Market (MTM): The current market value of a financial instrument.Option: The right (but not the obligation) to buy (or, conversely, sell) some underlying instrument at a pre-determined rate on a pre-determined expiration date in a pre-set amount.Over-the-Counter: Any transaction that takes place between two counterparties and does not involve an exchange is said to be an over-the-counter transaction.Put Option: A put option is a financial contract giving the owner the right, but not the obligation to sell a pre-set amount of the underlying at a pre-set price with a pre-set maturity date.